S Corp Shareholder Not Entitled to Basis Increase as Loan Guarantor and Co-Borrower

(Parker Tax Publishing July 2018)

The Eighth Circuit held that an S corporation shareholder could not increase his basis in the S corporation by the amount of loans to the S corporation where the shareholder signed loan documents as either a co-borrower or guarantor because the shareholder was never called on to make a payment and was not the primary obligor on any of the loans. The court also held that the shareholder's wife, who was a partner in partnerships that did business with the S corporations, failed to substantiate her basis in the partnerships' liabilities because the evidence did not show whether certain loans to the partnerships were recourse or nonrecourse or how the liabilities were allocated among the partners. Hargis v. Koskinen, 2018 PTC 184 (8th Cir. 2018).

Bobby and Brenda Hargis bought and operated nursing homes. Mr. Hargis was the sole owner of S corporations that operated the homes. Mrs. Hargis owned interests in limited liability companies (LLCs) taxed as partnerships that bought and leased the homes to the S corporations. All of the entities had net operating losses, which the Hargises deducted on their joint returns for 2009 and 2010.

The S corporations had no real assets or working capital, and borrowed to finance operations when revenues were insufficient. They borrowed from commercial lenders, the nursing home LLCs, and each other. All the money was paid directly to the S corporations to operate the homes. Mr. Hargis signed the loans as a co-borrower or guarantor. He admitted that none of the loans were debts of the S corporations to him. The LLCs also took out bank loans in 2005 and 2009.

The IRS issued a notice of deficiency disallowing the Hargis's losses due to insufficient basis in their business etities. As a result, the Hargises owed over $281,000 in taxes for the years at issue. In assessing the deficiency, the IRS estimated Mrs. Hargis's basis in the LLCs based on the Schedules K-1s she received.

The Hargises petitioned the Tax Court, which agreed with the IRS that the loans to the S corporations did not create basis for Mr. Hargis even though he signed the loan documents as a co-borrower or guarantor. The court also found that Mrs. Hargis did not present enough evidence of her basis in the LLCs to shift the burden of proof to the IRS. The Hargises appealed that decision to the Eighth Circuit.

Under Code Sec. 1366, S corporation losses can be deducted only to the extent a shareholder has basis in the corporation. A shareholder's basis in the sum of the basis in the stock and the basis of any debt of the S corporation to the shareholder. To obtain basis in debt, a shareholder must make an actual economic outlay that makes the shareholder poorer in a material sense. The loan must be in substance an investment representing genuine indebtedness. A shareholder's guaranty does not create basis until the shareholder is actually called on to satisfy the S corporation's debt.

Observation: The economic outlay doctrine led to frequent disputes over whether shareholder loans created basis. In response, the IRS issued regulations in 2014 which provide that, in order for an S shareholder to increase basis in indebtedness, the shareholder need only prove that the debt is a bona fide debt under federal tax principles.

A partner's basis in a partnership interest is increased by the partner's share of partnership liabilities under Code Sec. 752. A partner's share of liabilities includes recourse debt if the partner bears the economic risk of loss and includes an allocation of nonrecourse debt.

Mr. Hargis argued that the loans from third parties to the S corporations were in substance loans to the S corporations from him. He reasoned that the loans from the LLCs reduced Mrs. Hargis's capital account balance. As a co-borrower, Mr. Hargis claimed that lenders looked primarily to him for payment and could force him to pay without first seeking payment from the S corporations and that he was therefore directly liable. Mr. Hargis asserted that when he subsequently sold the S corporations in 2014, he received a discounted price due to the S corporations' debt.

Mrs. Hargis also claimed an increased basis in the LLCs as a result of her share of the loans to the LLCs. As proof, she presented agreements showing bank loans to the LLCs. Another member of the LLCs also testified that liabilities were allocated to members based on their percentage ownership.

The Eighth Circuit affirmed the Tax Court's holding that the Hargises did not have the requisite basis in loans to the S corporations or LLCs to deduct losses from those entities. The court rejected the argument that Mr. Hargis's basis was increased because the loans from the LLCs to the S corporations reduced Mrs. Hargis's capital account balance. The court reasoned that indirect lending, even from a closely related entity, does not create basis. The court also found that Mr. Hargis did not have basis as a result of being a co-borrower or guarantor because he was never called on to make good on any debt. The court found that if Mr. Hargis had ever been forced to pay the S corporations' debt, he would have made an actual economic outlay, but because that never happened, he did not have basis in the loans.

The Eighth Circuit also rejected Mr. Hargis's argument that lenders looked primarily to him for repayment. In the court's view, there was no evidence that any lender saw Mr. Hargis as a primary obligor. The fact that the debts reduced the sale price of the S corporations showed to the court only that debt makes a company less valuable, not that Mr. Hargis personally paid any of the debt. The court further noted that the lenders advanced the funds directly to the S corporations, and that no shareholder personally pledged any assets as collateral. The court acknowledged that the S corporations were thinly capitalized but reasoned that the mere presence of risk did not require a finding that the lenders could not expect repayment from the S corporations.

The Eighth Circuit also upheld the Tax Court's holding that Mrs. Hargis failed to substantiate her basis in loans to the LLCs. The Eighth Circuit found that the evidence Mrs. Hargis offered was insufficient because it did not show whether the loans were recourse or nonrecourse or whether any partner bore the economic risk of loss. The court also found no evidence beyond the generalized testimony of the other member (who, the court noted, was not involved in preparing tax returns) of the allocation of the debts to LLC members. Thus, the Eighth Circuit concluded that Mrs. Hargis's share of the loans could not be calculated. The court explained that even if Mrs. Hargis had provided evidence of her share of the loans, it would show only a one time increase in her basis, which would be just one factor in determining her basis for the later years, as the increase could have been offset by a number of other events.

For a discussion of a shareholder's basis in S corporation debt, see Parker Tax ¶32,840. For a discussion of the treatment of partnership's liabilities, see Parker Tax ¶25,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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